Case C58

Judges:
AM Donovan Ch
GR Thompson M
RK Todd M

Court:
No. 2 Board of Review

Judgment date: 1 October 1971.

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A.M. Donovan (Chairman), G.R. Thompson and R.K. Todd (Members): The assessment before the Board in this reference relates to the year of income ended 30 June 1965, during which the taxpayer company carried on business as land dealer and financier and, during which, in addition to deriving income from these sources, it derived rent, procuration and administration fees. It also derived $119,520 by way of dividends from H. Pty. Ltd., L Pty. Ltd. and G Pty. Ltd., all three of which companies were engaged in land dealing in one form or another. The taxpayer's return, which was accepted by the Commissioner without alteration, disclosed a taxable income of $119,170, which was slightly less in amount than the gross dividends received. Amongst the deductions allowed by the Commissioner was interest totalling $41,148, of which sum $36,472 was regarded by him as relating to the dividend income. Accordingly he deducted this sum from the gross dividends to determine a net amount of $83,041 dividends included in the taxable income by reference to which figure he calculated the rebate allowable under sec.46. The company's objection challenges this action. It was submitted on its behalf that no interest should have been offset against the dividends received in consequence of which the whole of the taxable income would have been rebateable pursuant to sec.46.

2. The facts are fairly simple, but it is necessary to go back to 30 June 1963, at which date the issued and paid up capital of the taxpayer was $40,639. There were then accumulated losses totalling $48,812 and the deficiency of $8,173 in shareholders' funds was for all practical purposes represented by a bank overdraft secured by guarantee. For reasons which were not explained, the taxpayer company attracted the interest of Messrs. O, J, and M, who acquired shares in it and decided to resurrect it from its moribund state. As a step in the process of revitalisation, they decided that the taxpayer should acquire part of their interests in H Pty. Ltd., L Pty. Ltd. and G Pty. Ltd., in which they held all the issued capital equally. Before this decision was carried into effect, the capital of the three companies was reconstructed. In the first place, land owned by them was revalued and amounts totalling some $240,000 were credited to reserve accounts. Next, a part of the capital was converted to B class shares. Each of the three members then held 10 such shares in H Pty. Ltd., 25 in L Pty. Ltd. and 1.000 in G. Pty. Ltd., which were sold to the taxpayer about 30 September 1963, for $25,946, $22,386 and $75,006 respectively. It should perhaps be mentioned that Mr. M held some of these shares beneficially and some on behalf of a company, M Pty. Ltd.

3. It was not surprising to find that the taxpayer was unable to pay cash for the shares it purchased. The agreed statement of facts dealing with this aspect of the case states: ``The purchase price of the shares was satisfied by the issue to the vendors of fully paid unsecured convertible notes bearing interest at the rate of 8% per annum from 1 July 1964.'' No interest was paid on these notes because, as the statement continued: ``On 27 January 1965, the shareholders, in general meeting, authorised the exchange of the unsecured convertible notes for unsecured loans bearing interest at 10 % from 1 July 1964,... and all the convertible notes were so exchanged.'' As a consequence of this exchange, the individual accounts of Messr. O and J in the taxpayer's books were each credited with the amount of $123,338, and the accounts of Mr. M and M Pty. Ltd. with amounts of $21,870 and $101,468 respectively. During the year ended 30 June, 1965, that is to say the year under review, the accounts of Messrs. O and J and M Pty. Ltd. were debited with amounts paid by the taxpayer on their behalf, such amounts totalling $16,400, $18,400 and $14,400 respectively. On 30 June, 1965, Messrs. O and J each repaid $4,000. Interest at the rate of 10% per annum on the amounts owing by the taxpayer, totalling in all $36,471, was credited in the books during the year and paid in cash shortly after the close of the year. The interest paid was not in any way affected by the repayments of $4,000 made by Messrs. O and J on 30 June, 1965.

4. The problem before the Board involves a consideration of sec.46(1) and (3) and sec.50(a). The material parts of sec. 46 are -

``(1) Subject to this section, a shareholder being a company which is a resident shall be entitled to a rebate in its assessment of the amount obtained by applying to that part of the dividends included in its taxable income the average rate of tax payable by the company.

(3) The part of the dividends so included in the taxable income of the shareholder shall be the amount remaining after deducting from the amount of dividends included in its assessable income deductions allowable to it under this Act from income from dividends.''

Section 50 provides -

``Where the assessable income is derived from more than one of the following classes of income, that is to say, income from personal exertion, income from property other than dividends, and income from dividends, the following provisions shall apply to all allowable deductions -

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(a) where a deduction or part of a deduction relates directly to income from dividends (whether of the year of income or of a previous year of income) the deduction or part of the deduction, as the case requires, shall be made successively from income from dividends, from income from property other than dividends, and from income from personal exertion.''

5. The question as to how much of a particular class of income is included in taxable income has frequently engaged the attention of the Courts. Examples, when a consideration of a provision like sec.50 was not required, are to be found in
Douglass v. F.C. of T., 45 C.L.R. 95, and in
Commercial Banking Co. of Sydney v. F.C. of T., (1950) 81 C.L.R. 263. In the latter case, at p.309, Dixon, J., in dealing with the quantum of income subject to rebate under sec.160AB, said: ``I construe sec.160AB as in effect meaning that a taxpayer is to be entitled to a rebate in his assessment on an amount of 2s. in every pound of interest by reason of the inclusion of which in his assessable income his taxable income has been increased. It will be seen that upon this meaning the rebate cannot be upon more than the taxable income which, of course, is obvious enough, and, further, that if there are any special deductions which, but for the inclusion of the interest in the assessable income, would not be allowable, they are to be thrown against it. None of the deductions, however, in the present cases are of this character.'' It is to be observed that the Court in that case rejected an attempt by the Commissioner to offset expenses which were incurred in carrying on the taxpayer's business against interest which it derived on Commonwealth loans.

6. When sec.50 has impinged on the problem, the Commissioner has been no more successful before the Courts in his attempts to allocate deductions to the class of income under consideration. The situation was succinctly set out in
Palvestments Pty. Ltd. v. F.C. of T., (1965) 112 C.L.R. 661. In that case, the taxpayer challenged the Commissioner's action of applying to dividend income a proportion of the interest on overdraft, no part of which was shown to have been used to acquire the shares producing the dividends in question. At p.664, Menzies, J. observed -

``It seems to me that what the Commissioner has done here is not substantially different from what was unsuccessfully attempted in a number of earlier cases:
North Australian Pastoral Co. Ltd. v. F.C. of T. (1946) 71 C.L.R. 623; Commercial Banking Co. of Sydney Ltd. v. F.C. of T. (1950) 81 C.L.R. 263;
Australian Machinery & Investment Co. Ltd. v. D.F.C. of T. (1946) 8 A.T.D. 81; and
Modern Permanent Building and Investment Society (In Liquidation) v. F.C. of T. (1958) 98 C.L.R. 187.

It was argued for the Commissioner that, as in
Rowdell Pty. Ltd. v. F.C. of T. (1963), 111 C.L.R. 106, it was decided that the phrase `Income tax deductions allowable' in sec.46(3) refers in anticipation to the provisions of sec.50(a), the earlier cases such as North Australian Pastoral Co. Ltd.'s case have lost some of their authority, but I do not see any basis for this. In North Australian Pastoral Co. Ltd.'s case the attempt to apportion the general expenses of conducting the business and to attribute a proportionate part to dividends failed, Dixon, J. (as he then was), saying: `... the substance of the contention is that a reasonable estimate of the proportion of the deductions allowed as the operating expenses of the company which ought to be attributed to the dividends is one per cent upon the amount of the dividends and that it is unnecessary that there should be any specific connection between the dividends and the expenses. I do not so read sub-sec.(3) of sec.46.' - (1946) 71 C.L.R., at pp.635, 636. I cannot see how the decision in Rowdell's case, supra, that a deduction or part of a deduction relating directly to income from dividends (sec.50(a)) is a deduction allowable from income dividends (sec.46(3)) assists the Commissioner's attempt to apportion interest in a case where I am not able to infer that any part of the interest paid in the year ended 30 June 1962 related directly to the dividend income of that year or any previous year of income.''

7. `Rowdell's case (111 C.L.R. 106) to which Menzies, J. referred in the passage quoted above, is of some significance in the present instance because counsel for the taxpayer adopted an argument addressed to the Court in that case. It was there submitted that the taxable income has to be ascertained from the return lodged by the taxpayer and, notionally another return has to be prepared omitting the dividend income and allowing all deductions to which the taxpayer is entitled in that altered situation. The difference between the two figures represents the amount of dividends included in the actual taxable income. This argument may well have been suggested by the observations of Dixon, J. in the Commercial Banking Co. case, which was quoted above, and in which there was a similarity of fundamental facts, but in any event it was not in terms adopted by the Court. The facts in the present instance are quite dissimilar from those in the cases mentioned, or for that matter in any of the reported cases. The use of the argument in this reference involves, we

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think, this process of reasoning: If it be conceded that the interest relates to the taxpayer's shareholding in the three companies in question, that interest is deductible whether or not the shares produce dividends in any particular year, and, if one literally applies what was said by Dixon, J., the interest cannot be offset against the dividends for the purposes of sec.46. But his Honour's dictum appeared in a completely different context and we do not interpret it as having any relevance in the present circumstances. In our opinion there is no basis for the argument.

8. The critical words for present purposes occur in the passage in sec.50(a) ``where the deduction... relates directly to income from dividends...'' The words are plain and unambiguous, and perhaps all that need be noticed is that they express a somewhat different notion from the operative words in the succeeding section which define the deductibility of outgoings. The question then is whether the interest in question ``relates directly'' to the dividends. As has been mentioned, the shares which produced the dividends were not paid for in cash. On the basis of the material put before the Board, it is not possible to decide whether the taxpayer's initial debt to the vendors in respect of the amount owing on the shares was extinguished by their acceptance of unsecured notes. Let it be assumed that the original obligation was discharged, and let it also be assumed that the substituted obligation pursuant to the unsecured notes was extinguished in turn by the exchange of the notes for ``unsecured loans'' (as it was put). Nevertheless, the successive steps have done nothing to bring into existence new assets or introduce new funds to the company and have merely precisely replaced the existing liability. There has been an exact substitution of the last obligation for the first liability which represented the purchase price of the shares in question upon which the dividends were declared and nothing else. The last obligation therefore relates to the shares in question, and it is an accepted use of language to say that it relates ``directly''. The same process of reasoning leads to the conclusion that the interest payable in respect of the last obligation ``relates directly'' to the dividends produced by the shares. The interest paid to the vendors of the shares was still paid exclusively in respect of amounts of moneys borrowed to acquire the shares upon which dividends were declared, and which amounts equalled the unpaid purchase price of the shares. It follows that the Commissioner was correct in setting off against the dividends of $119,500 received from H Pty. Ltd., L Pty. Ltd. and G Pty. Ltd. the interest of $36,472 paid to the vendors of those shares in the circumstances described.

9. This conclusion involves the rejection of an alternative argument upon which counsel relied. He submitted that the interest in question was ``in a sense simply interest paid on funds which were of necessity in the company contributed by the shareholders as an alternative to share capital''. It is perfectly true that the taxpayer was seriously undercapitalised and had sufficient funds to pay for the shares it purchased. If it had been required to provide cash in payment it would, no doubt have had to obtain funds from some source - probably the shareholders. The course adopted obviated this necessity and permitted the use of it existing resources in other fields, but in our view the interest paid on the unsecured loans was not in any sense paid on funds employed generally in the business. That interest related directly to the share in the three companies and to the income those shares produced.

10. We would uphold the Commissioner's decision on the objection.

Claim disallowed